C&B Notes

Financial Modelers’ Manifesto

We have recently explored a glaring shortcoming of many current financial models: their inability to appropriately account for the frequency of “outliers” (here and here).  In their Financial Modelers’ Manifesto, Emanuel Derman and Paul Wilmott take a step back from this particular focus and explore financial modeling from a broader, more holistic perspective.  Their takeaways are insightful (in fact, we like the entire manifesto so much that we have added it to our recommended reading list):

Physics, because of its astonishing success at predicting the future behavior of material objects from their present state, has inspired most financial modeling.  Physicists study the world by repeating the same experiments over and over again to discover forces and their almost magical mathematical laws.  Galileo dropped balls off the leaning tower, giant teams in Geneva collide protons on protons, over and over again.  If a law is proposed and its predictions contradict experiments, it’s back to the drawing board.  The method works.  The laws of atomic physics are accurate to more than ten decimal places.

It’s a different story with finance and economics, which are concerned with the mental world of monetary value.  Financial theory has tried hard to emulate the style and elegance of physics in order to discover its own laws.  But markets are made of people, who are influenced by events, by their ephemeral feelings about events and by their expectations of other people’s feelings.  The truth is that there are no fundamental laws in finance.  And even if there were, there is no way to run repeatable experiments to verify them.

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We do need models and mathematics — you cannot think about finance and economics without them — but one must never forget that models are not the world.  Whenever we make a model of something involving human beings, we are trying to force the ugly stepsister’s foot into Cinderella’s pretty glass slipper.  It doesn’t fit without cutting off some essential parts.  And in cutting off parts for the sake of beauty and precision, models inevitably mask the true risk rather than exposing it.  The most important question about any financial model is how wrong it is likely to be, and how useful it is despite its assumptions.   You must start with models and then overlay them with common sense and experience.

Emanuel Derman has actually further explored these ideas (and more) in a recently released book.  Burton Malkiel, author of “Random Walk Down Wall Street,” wrote an interesting review at WSJ.com.

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